With more and more American households accruing high balances on credit cards and loans, finding creative solutions to repaying debt is critical.
One option when you owe money to many creditors is a strategy known as debt consolidation. By consolidating your debt, you can organize your accounts in one place and often benefit from a lower-interest window in which to begin paying your balances.
However, debt consolidation is not without its drawbacks. One of the more pressing questions you may be asking yourself is: Does debt consolidation hurt your credit score?
How debt consolidation can affect your credit score
Debt consolidation is a process in which you take out one loan with a lower interest rate to pay off several other loans or credit card balances that charge more in interest. Your total debt won’t be reduced, but paying it off may be easier or less expensive.
However, debt consolidation will affect your credit score, at least in the short run. When you consolidate your debt through a loan, whether it’s a personal loan, home equity loan or line of credit, a few things take place that will all likely lower your credit score.
Hard inquiry is performed
Whenever you apply for a loan, a lender will perform a hard inquiry on your credit to review your payment history. This automatically lowers your credit score by a few points.
New account is opened
If approved for the loan, you’ll have a new credit account on your report. This will likely lower your credit score a bit.
Average credit age drops
The average age of all of your accounts is an important metric in your credit score. When you open a new account, your average account age is adjusted and can temporarily lower your credit score.
While it can be tough to watch your credit score decrease, especially when you’re working to improve the health of your finances, debt consolidation can improve your credit over time.
Lower credit utilization ratio
Part of your credit score is how much of your available credit you’re using. By taking out a new loan, you’re increasing the amount of available credit you have and ideally lowering your ratio (as long as you don’t continue to acquire new debt). For example, if you had a credit card with a $10,000 credit limit and you owed $5,000, your credit utilization would be 50 percent. Once you pay off this card and others like it, your credit utilization will drop.
Improved payment history
As you make your debt consolidation loan payments (on time, of course), you’ll see your credit scores begin to rise. Payment history is the biggest factor when calculating credit scores, so make your payments a top financial priority.
3 alternatives to debt consolidation loans to consider
If debt elimination is your goal but you’d rather not take out a debt consolidation loan, there are a few alternatives you can consider.
1. Debt settlement
Debt settlement could be an option if a low credit score has prevented you from securing a debt consolidation loan. With debt settlements, you make payments to a savings account managed by a third-party settlement company and stop making payments to your creditors.
Once a large sum has been saved, the settlement company will contact your creditors and offer to pay them a percentage of your total debt if they forgive the remainder. Your credit score will certainly take a hit with this initial nonpayment approach, but if you believe you can avoid falling back into a debt trap, this could be a faster way to eliminate your debt and get on the right path to a better credit score.
2. Balance transfer credit card
A balance transfer credit card essentially puts your debt on hold. Look for a balance transfer card with a 0 percent promotional APR offer. The longer you can hold onto a 0 percent APR offer, the better. These offers normally last 12 to 18 months. This means that the transferred balances on your new card won’t accrue interest until the introductory period ends. Often, there is an upfront balance transfer fee of 2 percent to 5 percent of the amount you’re transferring. So, if you’re transferring a balance of $5,000 at a 5 percent fee, you’ll be charged $250.
However, we suggest this approach only if you can avoid using your credit cards entirely and not rack up new debt. Similar to a debt consolidation loan, you can also expect your credit score to take a bit of a hit initially when opening up a new account but improve as you make timely payments and improve your credit utilization ratio.
3. Rework your budget
There are two approaches you can take when reworking your budget: either make more money or spend less money.
If you can do a combination of the two, you’ll find yourself debt-free much faster. For example, try cutting back on how many times you dine out each month or switch to a less expensive streaming service for your entertainment. To boost your income, work a temporary part-time job or hold a garage sale.
The bottom line
Debt consolidation can hurt your credit, but typically only in the short term. As long as you avoid diving back into debt and make timely payments that meet or exceed the minimum monthly payment, you’ll see your credit score improve over time.